Archive for the ‘Audit’ category

Is the IRS getting closer to ferreting out “quiet disclosures” by taxpayers who chose that route to address the problem of previously unreported offshore accounts rather than by participating in the Service’s offshore voluntary disclosure program (OVDP)? That’s the conclusion of an increasing number of tax professionals and if taxpayers in this predicament weren’t already worried, they should be.

A quiet disclosure involves the filing of new or amended tax returns that report offshore income, and FBARs (Report of Foreign Bank and Financial Accounts) that provide other account information regarding the taxpayer’s interest in foreign accounts. It is a discreet disclosure intended to make a taxpayer compliant with his or her tax reporting responsibilities while avoiding penalties imposed under the IRS’s official voluntary disclosure program.

The IRS has made no secret of its distain for those who choose the quite disclosure route over participation in its voluntary disclosure program. In its frequently asked questions and answers applicable to the most recent iteration of the OVDP, the Service has cautioned taxpayers that those who have already made quiet disclosures should “be aware of the risk of being examined and potentially criminally prosecuted for all applicable years.” The IRS has encouraged such taxpayers to “take advantage” of the program before discovery. The FAQs also note that detection of a quit disclosure also eliminates the possibility of reduced penalty exposure offered under the OVDP. (See FAQs 15 & 16.)

To some, the calculus about whether to participate in the OVDP, follow the quiet disclosure path, or do nothing has been viewed as another form of the audit lottery, albeit one with very high stakes in terms of potential monetary penalties and possibly criminal prosecution. As virtually everyone should know at this point, offshore account holders can no longer rely on bank secrecy to protect them, so the issue of detecting unreported accounts has become more a question of when, not if. Although a quiet disclosure addresses the unreported account problem, either currently or retroactively, that is not necessarily the end of the story . . . or the risk.

Earlier this year, the Government Accounting Office issued a report in which it noted a dramatic increase in the number of taxpayers reporting offshore accounts, concluding that the trend may reflect attempts to minimize or circumvent taxes, penalties and interest that would be owed if not corrected before detection or even upon participation in the OVDP. Among other things, the GAO recommended that the IRS explore methodologies to detect and pursue quiet disclosures. Apparently, the IRS has taken the GAO’s recommendation to heart by working on new ways to identify them. The effort, according to former Acting IRS Commissioner Steven Miller, was to include “analysis of Forms 8938, Statement of Specified Foreign Financial Assets, to identify specific characteristics of the filing population and to assess filing behaviors indicating potential compliance issues.”

In predicting the effectiveness of this undertaking, it is worth noting that the IRS has a wealth of experience in implementing computer algorithms on a much larger scale to ferret out trends warranting closer scrutiny. One need look no further than the Services’ Discriminant Function System (DIF), which is used to flag tax returns for possible audit, among the hundreds of millions filed, to appreciate that improved detection of quiet disclosures is well within the IRS’s capabilities. Therefore, taxpayers who rely on a limited IRS resources justification to ignore the directional trend regarding quiet disclosures are likely to wish they had examined the issue relative to their own personal circumstances a lot more closely. At the very least, given the prevailing wind on this issue, it would be prudent for those who have made quiet disclosures or are contemplating one to revisit the issue with their tax adviser.

Any corporate tax executive who has ever been involved in contesting an audit adjustment knows all too well how unfavorable documents relating to the subject of the adjustment – particularly improvident comments reflected in email correspondences – can be an ongoing impediment to resolving a tax dispute from the audit phase right up to and through litigation with the IRS or Department of Justice. When such documents exist, even where taken out of context, the government will zealously sink its teeth into them like a junkyard dog, making the prospects of reaching a reasonable settlement or gaining an IRS concession all the more difficult. One can’t fault the government for taking a hardline position. Precedent reflects that this is a good strategy, particularly in economic substance cases, as demonstrated by the numerous times these unfavorable documents work their way into the text of court opinions as the factual underpinning for an adverse finding against the taxpayer. Like a Dickensian character, they will come back to haunt you again and again.

The solution, of course (conveniently ignoring the practical realities of many understaffed and overburdened tax departments), is for the tax function to do a better job of policing both document production and retention policies, particularly outside of its own direct jurisdiction and normal supervision. Non-tax business justifications pervade so many tax disputes that it is incumbent on the tax executives to ensure that these justifications are not only well-documented, but consistently followed in practice after the transaction is put into place. The tax folks are, after all, the ones ultimately on the front lines defending the non-tax business justification. As they say, it’s like cleaning up after the elephants in the circus parade – unpleasant but necessary.

In the course of this process, it is important to remain mindful that once documents are created, particularly in connection with a transaction where future litigation may reasonably be anticipated, a duty to preserve via a litigation hold may override a company’s normal document destruction policies. See e.g., Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir.2001) (duty to preserve evidence “arises not only during litigation but also extends to the period before the litigation when a party reasonably should know that the evidence may be relevant to anticipated litigation.”) Indeed, the failure to put a litigation hold in place can have deleterious consequences, from waiver of attorney work product protection (see e.g., Samsung Electronics Co., Ltd.. v. Rambus, Inc., 439 F. Supp. 2d 525 (ED Va. 2006) (rev’d on other grounds, 523 F.3d. 1374 (Fed. Cir. 2008)), to IRS challenges regarding the completeness of a taxpayer’s Schedule UTP disclosures (which does not require reserves to be recorded for positions “expected to be litigated”), a topic I have written about before. Simply put, it is difficult to persuasively argue that an issue was reasonably anticipated to be litigated (e.g., for work product protection or UTP purposes), where there is a failure to implement a litigation hold predicated on that very anticipation.

Earlier this month, U.S. District Judge Shira Scheindlin (S.D.N.Y.), author of the landmark Zubulake opinion on electronic discovery, raised the stakes further when she ruled, in Sekisui American Corp. v. Hart, 2013 WL 4116322 (S.D.N.Y. Aug. 15, 2013), that a party who failed to preserve electronically stored information (ESI) by not implementing an adequate litigation hold was subject to an adverse inference about the content of such evidence. The ruling was notable because it bucked the trend of courts to overlook a party’s destruction of ESI in the normal course of its business practices, notwithstanding the obligation the party may have had to implement a litigation hold to preserve such documents. (See Fed. R. Civ. P. 37(e), requiring “exceptional circumstances” to impose sanctions.) In Sekisui, Judge Scheindlin imposed the adverse inference sanction (in addition to monetary damages) even without finding any malevolent intent or substantial prejudice to the opposing party. The court simply ruled that the failure to implement a litigation hold was enough to constitute a willful intent to destroy documents.

It doesn’t take a great deal of imagination to appreciate that a ruling invoking an adverse influence as a result of the failure to preserve documents can be fatal, an even more likely outcome in a bench trial where the judge making the ruling is also the trier of fact. At the very least, being slapped with such a sanction will preclude any benefit of the doubt that documents interpreted negatively by the IRS may be accorded a more favorable interpretation by the trier of fact.

I have heard – certainly more than once – government counsel advocate to a court words to the effect that “memories fade but documents never lie.” It is true that the odds of prevailing in a tax dispute are not helped by poor recordkeeping practices, by which I include both shoddy documentation as well as carelessly policed documentation containing ill-conceived content readily subject to misinterpretation and misuse.

If nothing else, the ruling of an influential jurist like Judge Scheindlin should heighten tax departments’ sensitivities about monitoring company recordkeeping practices from the outset of a transaction. These efforts should be quantitative in terms of fully apprehending the documents to be generated and maintained, and qualitative to reduce the risk that problematic documents are generated carelessly and maintained thoughtlessly. No less thought should be put into the timely implementation of litigation holds to ensure that company records – hopefully those that will help it carry the day in a tax dispute – are adequately preserved, particularly when the ramifications of their destruction can exponentially increase the likelihood of an unfavorable outcome.

With the looming increase in tax rates on investment income and capital gains in particular, a large number of stock market investors have been selling long-term positions to lock in the 2012 rate, which currently tops out at 15%. Come January 1,2013, gain on the same sale could be taxed at a rate as high as 23.8%, consisting of a long-term capital gains tax rate of 20% plus a Medicare surtax of 3.8% imposed on joint filers with AGI greater than $250,000 and single filers with AGI greater than $200,000. (See Internal Revenue Code § 1411).

A question attracting attention as the year draws to a close and the pace of this activity has accelerated has been whether a stock sale undertaken solely to take advantage of the lower 2012 capital gains tax rates might fall within the scope of Code § 7701(o), the relatively new economic substance statute codified as part of the landmark Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029). Concerns about coming within the scope of this statute are that it might subject the investor to a 20% penalty enacted as part of the new law. See Code § 6662(b)(6). The penalty, if applicable, is a “strict liability” one, which means that taxpayers cannot avoid it on grounds of reasonable cause, such as reliance on a tax advisor. (The penalty for a transaction determined to lack economic substance is also increased to a whopping 40% if the transaction is undisclosed. See Code § 6662(i). However, as long as a taxpayer reports the transaction on his or her tax return, the 40% penalty should not apply.)

Thankfully, the eleventh hour concerns expressed about this issue should be put to rest for stock investment gain-recognition transactions in 2012. Even assuming the economic substance statute is conceptually broad enough to ensnare stock sale transactions undertaken to lock in lower capital gains tax rates, the penalty is only applicable to “underpayments.” Because a long-term capital gain recognized in 2012 does not reduce a taxpayer’s taxable income but rather increases it (unless the gain is offset by otherwise unused capital losses), there is no underpayment against which to apply a penalty.

Now let’s vary the circumstances by introducing a simultaneous buyback of the stock at the time of sale to reestablish the same position. Does that change anything vis a vis a potential penalty risk? We still have a gain recognition transaction in 2012, so there is no tax underpayment against which a penalty could apply for this year. As for the repurchased stock, its cost basis is at the repurchase price, which means that a subsequent sale in a future year will either produce a smaller taxable gain or larger taxable loss than would have occurred had the original share lots with their lower cost basis simply been maintained. Some have speculated that this could produce a tax underpayment against which the strict liability economic substance penalty might apply in the year of sale. After all, in defining a transaction that has economic substance, § 7701(o) requires (1) that the transaction change in a “meaningful way” the taxpayer’s economic position apart from federal tax benefits, and (2) that the taxpayer have a non-tax purpose for entering into the transaction.

In theory, a sale and instantaneous repurchase might fail to satisfy both of these tests. On the other hand, a repurchase transaction that occurs sometime after the sale introduces an element of market risk from stock price fluctuation that should mitigate any penalty risk. Similarly, a repurchase in a different type of account (e.g., in a tax-deferred account where the original sale was in a taxable account or vice versa) should also put the taxpayer on firmer ground.

So what are the real risks that the IRS might choose some unfortunate taxpayers to assert a strict liability penalty? It has, after all, been less than forthcoming in providing guidance on what types of plain vanilla transactions, if any, may be viewed as falling within the scope of the new economic substance statute. Perhaps the best indicator one can draw upon is the title of § 7701(o), “Clarification of Economic Substance Doctrine.” The codified doctrine has been portrayed as merely a clarification of the economic substance law in effect for transactions entered into before March 30, 2010. Under the pre-codification doctrine, which is derived solely from the common law, there do not appear to be any reported economic substance cases involving a taxpayer’s sale and repurchase transaction that results in accelerated gain recognition. Couple this with the fact that no court has been asked to interpret the breadth of the new economic substance statute since it was passed in 2010, and it is reasonable to believe that the IRS would prefer to choose a different, and presumably more compelling battleground to make its first stand defending the application of Section 7701(o) and the strict liability penalty.

Finally, in the case of a 2012 gain-recognition stock sale and simultaneous repurchase, it cannot be entirely certain that the transaction will even produce a tax savings when all is said and done. This is because of the difference between the tax rates for long and short term capital gains (which are taxed at ordinary income rates). Because a new holding period is established for the repurchased stock, it remains possible that the stock, when sold, will produce a short-term capital gain subject to a larger tax burden than might have occurred if if the original long-term position was held into 2013 or beyond. In the end, the lack of certainty about the ultimate tax effect until the second sale occurs may be taxpayers’ best argument that the sale and repurchase transaction had economic substance after all.

Whether a worker is performing services as an employee or as an independent contractor depends on the facts and circumstances. This determination may be difficult for many companies and may lead to significant exposure. In order to facilitate voluntary resolution of potential worker classification issues and achieve the benefits of increased tax compliance and certainty for all parties, taxpayers, workers and the government, the IRS established the Voluntary Classification Settlement Program (“(VCSP”) on September 11, 2011. The program was created to allow for voluntary reclassification of workers as employees outside the administrative context.

In light of feedback received, today the IRS has announced changes to the VCSP. (Announcement 2012-45; 2012-51 IRB 724). The VCSP has been modified to: 1) permit a taxpayer under IRS audit, other than an employment tax audit, to be eligible to participate in the VCSP; 2) clarify the current eligibility requirement that a taxpayer that is a member of an affiliated group within the meaning of section 1504(a) is not eligible to participate in the VCP if any member of the affiliated group is under employment tax audit; 3) clarify that a taxpayer is not eligible to participate in the VCSP if the taxpayer is contesting in court the classification of the class or classes of workers from a previous audit by the IRS or the Department of Labor; and 4) eliminate the requirement that a taxpayer agree to extend the period of limitations on assessment of employment taxes as part of the VCSP closing agreement with the IRS.

In addition, today the IRS announced a temporary expansion of eligibility for the VCSP through June 30, 2013. The temporary eligibility expansion makes a modified VCSP available to taxpayers who would otherwise be eligible for the current VCSP but have not filed all required Forms 1099 for the previous three years with respect to the workers to be reclassified. Eligible taxpayers that take advantage of this limited, temporary eligibility expansion agree to prospectively treat workers as employees and will receive partial relief from federal employment taxes. (Announcement 2012-46; 2012-51 IRB 725)

This program can be used as a tax planning tool with the advice of your tax counsel.

Concerned about the extent of international tax non-compliance, Congress enacted the Foreign Account Tax Compliance Act (“FATCA”). Among other provisions found in FATCA was Section 6038D, which requires certain individuals to annually report to the IRS data about their interests in foreign financial assets. Sounds simple enough, right? Well, this seemingly straightforward obligation has been causing significant havoc for taxpayers and their advisors in 2012, as they wrestle for the first time with tricky new issues when deciding whether and/or how to complete Form 8938 (Statement of Specified Foreign Financial Assets).

Given the challenges associated with the current rules and the finalization in the near future of additional regulations expanding the coverage of Section 6038D, uncertainty will persist for some time. Confusion about Section 6038D and Form 8938 can trigger a series of negative results for taxpayers, including new information-reporting penalties, increased accuracy-related penalties, criminal charges, extended assessment periods, and a fight with the U.S. government on three fronts simultaneously. Confusion about this new international tax requirement could cause severe problems for tax advisors, too, because misinformed clients facing IRS problems tend to point their fingers (and their malpractice firms) squarely toward the trusted tax professionals on whom they relied.

In an effort to avoid these types of problems, the attached article, which was recently published in the May-June 2012 issue of the International Tax Journal, (i) contains a thorough analysis of the Form 8938 filing requirements, incorporating and digesting guidance from multiple sources, (ii) clarifies the confusing overlap between Form 8938 and the FBAR, and (iii) explains the unappreciated, severe consequences for taxpayers who fall into noncompliance.

In a recent TaxBlawg post, my colleague Jonathan Prokup discussed the IRS’ intention to begin requesting electronic files as part of taxpayer examinations so that it can analyze the “metadata” contained in those files. One of the concerns raised in the post, as announced in Chief Counsel Advice 201146017, was the possibility that such data in the hands of the IRS may be insecure and therefore potentially susceptible to theft by third-party hackers (which, by the way, could conceivably expose the IRS to damages for disclosure of taxpayer information under IRC § 6103). Concerns about metadata security, as highlighted in the post, are but one of a number of provocative issues arising from the explosive growth in electronic data (commonly referred to as “electronically stored information” or “ESI” in the parlance of the Federal Rules of Civil Procedure). Aldous Huxley’s Brave New Worldis upon us, and if your legal and IT departments are not already addressing these issues, tax executives should not be deterred from doing so. Among the issues implicated

Does your company have a comprehensive records retention policy in place and, even assuming that it does, can the company adequately prove its compliance with such policies if ever challenged?

Is that policy consistent with the requirements of IRC § 6001 and Treas. Reg. § 1.6001-1 to maintain and retain books and records “so long as the contents thereof may become material in the administration of any internal revenue law.” See Reg. § 1.6001-1(e).

Should your company attempt to negotiate a records retention limitation agreement with the IRS?

As part of its records retention policy, can and should your company institute a corporate policy of routine metadata scrubbing for certain types of corporate documents, and would such a policy be consistent with the requirements of Sarbanes-Oxley? (more…)

As reported earlier this week in the tax press, the recently completed initial filing season for Schedule UTP produced at least one major surprise in the eyes of IRS officials, who had anticipated a much greater number of items listed on the average Schedule UTP than actually materialized. In fact, the IRS’s predictions were off by a wide margin, with the number of disclosed positions of the 1,500 or so Schedule UTPs filed averaging only slightly more than three items per schedule for CIC taxpayers, and less than two items for non-CIC taxpayers. Pre-filing expectations of item disclosures had been many multiples higher, perhaps even reaching as high as 100 or more separately stated positions. Although such predictions may have been wildly optimistic from the IRS’s standpoint, one must now wonder whether the apparent failure of the first filing season to meet the Service’s anticipated disclosure bonanza will hasten efforts to extend the penalty regime to specifically target what are viewed as incomplete or inadequate disclosures on Schedule UTP. (more…)

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